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March 14, 2014

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Ralph Musgrave

Even if the capital ratio was raised to the 25% or so favored by Anat Admati (and Martin Wolf), depositors would still demand that taxpayers stood behind deposits. I.e. they’d ask for banks to be subsidised.

Second, private banks use their freedom to lend money into existence to do so like there’s no tomorrow in a boom, and then put the process into reverse in a recession: exactly what’s not needed. Ergo the ratio should be 100%. That disposes once and for all of bank subsidies AND the tendency of banks to exacerbate booms and busts.

Andrew

Fantastic.

Too few seem to describe the crisis in terms of an over-leveraged banking system.

Of course, regulation cannot stop such periodic boom-busts since it is actually part of the process. There were 12:1 leverage limits in place in the US right until Hank Paulson successfully lobbied to change them and allow leverage to explode for the largest banks.

So by all means impose regulation. It may work until next time, and that may be some time, but there is no indication anything useful will be imposed this time.

Andrew

Having said that, I'm not sure you can really absolve the central banks given the cheer-leading unidirectional asset-inflating role they seem to think is now theirs.

Dipper

So it was just the small matter of not having enough equity was it? Just a technical matter?

I think it was something much more serious than that. The west can no longer justify the standards of living it wishes to enjoy and was only able to do this through borrowing. When that finally ran out the banking system crashed, and without the taxpayer standing behind the banks every single one, irrespective of their equity ratio, would have gone bust.

Dipper

"RBS and Northern Rock didn't fail because lots of their loans turned bad. RBS failed because it didn't have a sufficient equity cushion to absorb losses at ABN Amro"

So it was ABN Amro that loaned all that money to Ulster Bank? £15,000,000,000 and counting ...

Frances Coppola

Chris, I agree that lack of capital was the main problem at RBS, but it would have failed even if it had not taken on ABN AMRO. It was a basket case through and through.

Bank lending is intrinsically pro-cyclical. Would you agree that some form of counter-cyclical prudential regulation would be sensible? I know the PRA is keen on counter-cyclical capital buffers - do we need the same for liquidity, too? And how do we address the political difficulty with applying counter-cyclical regulation - the fact that in the good times politicians don't want to stop the party, while in the bad times they want everyone to sign the pledge?

Dipper, Ulster Bank is a wholly-owned subsidiary of RBS. It is not correct therefore to speak of RBS "loaning" money to it.

Dipper

Frances,

Yes, I know Ulster Bank is owned by RBS - hence the property loans into Ireland from Ulster Bank currently £15Bn underwater all originated in RBS, not ABN Amro

Your point on politicians not wanting to stop the party is a good one, and one JK Galbraith made in his book The Great Crash. But its worse than that. Gordon Brown in a budget (2002?) stated that his genius (I paraphrase) had raised the run rate of GDP from 2.5% to 3%, and he promptly taxed the difference forward over several years. I said to our economist (not being one myself) that it seemed Brown had committed labour to extending the credit boom as a matter of policy, and how much of the extra GDP was in his opinion due to the credit boom? His answer - 150% of it - was in hindsight spot on.

Blissex

«It was this high asset-to-equity ratio that got banks into trouble. [ ... ] RBS failed because it didn't have a sufficient equity cushion»

That looks like a pointless truism: because obviously if there is enough spare capital to absorb losses, the losses don't cause insolvency. And in the chicken and egg issues of whether the losses were too big, or the loss reserves too small, the big question is relative to what.

As to that it is not a pointless truism, it is a misleading one, because there are actually more factors at play:

- Size of the credit book.
- Risk of the credit book.
- Amount and type of loss reserves.
- Value/liquidity of credit collateral.

If we look at those over time, the absolute size of loss reserves including capital did not shrink fast, it was both the size and the risk of the credit book that expanded dramatically, faster than GDP for decades; plus, crucially the delusions about the value of the collateral increased.

Sure, if loss reserves had grown faster than the credit book size, risk, and the delusions on collateral, everything would have been fine. But to me that's a ridiculous expectation.

In part because there was a strong political will, by both voters (borrowers), politicians and the finance industry to expand credit faster than GDP, and to use crude accounting techniques to pretend it was all good.

The principal technique was overvaluing collateral, by failing to note that the nominal value of that collateral was highly sensitive to credit growth, that as credit expanded the value of assets given as collateral would go up because of bidding wars by buyers eager to get rid of the fast-devaluing cash they had borrowed, and this would "justify" further credit growth.

Note: in particular thanks to remortaging: If a single house is bought at a higher price thanks to credit expansion, then all house valuations can go up, and remortgage credit expands "safely" on all houses, not just because of the mortgage on the one that was bought.

The debt-collateral spiral is a marvellous positive feedback loop much loved by central bankers (while they hate the price-wage spiral), but it can go into reverse.

«Northern Rock failed because it had funded loans by borrowing in wholesale markets, and those markets seized up in 2007.»

That seems to be a vast rewriting of history, the usual propaganda by central bankers that it was all just an innocent liquidity and not solvency crisis. Surely Northern Rock's failure was precipitated by a liquidity crisis, but they also had an exceptionally risky credit book with plummeting collateral values heavily linked to continued credit growth...

The Northern Rock "bad bank" seems to me in a very strange state (I think it is being thoroughly obfuscated by the government for propaganda purposes), but does not look like a solvent but illiquid business.

«Quantitative credit controls wouldn't have prevented all this. At a time when banks wanted to leverage up, such controls might instead have caused them to buy back equity.»

Credit controls or anything else would not have prevented that simply because there was overwhelming political will to boost credit faster than GDP to drive up asset (collateral) prices.

The credit bubble was not the result of mere technical mistakes as to whether regulate the amount of credit, or capital ratios, or interest rates, or accounting rules on the valuation of collateral.

It was the result of voters, governments and central banks making the political decision to transfer large amounts of income from feckless parasites living off undeserved labor income, to hard working, productive rentiers living off deserved capital gains (and bonuses related to credit growth). :-)

Blissex

«until Hank Paulson successfully lobbied to change them and allow leverage to explode»
«in the good times politicians don't want to stop the party,»
«it seemed Brown had committed labour to extending the credit boom as a matter of policy,»

All true, but shallow notes, because this is my usual point: the main responsibility falls on *voters* because it is voters (especially middle aged and older female property owners in the South East) who kept demanding for 25 years for ever better, bigger debt growth to give them massive tax-free capital gains cheaply cashable via remortgages.

Politicians had no choice in the matter, if they wanted to be re-elected. Of course they could have tried to at least moderate the size of the choice that *voters* had made, but it is hard work...

So it was not Brown who had committed Labour to extend the asset price bubble, it was *voters* who had. Confirmed by recent events, as the Coalition follows exactly the same policy, because *voters* demand it.

As per Tony Blair's 1987 analysis, my usual one:

http://www.lrb.co.uk/v09/n19/tony-blair/diary

Blissex

«The Northern Rock "bad bank" seems to me in a very strange state (I think it is being thoroughly obfuscated by the government for propaganda purposes),»

One of my readings of Coalition policies is that the Conservatives are fighting the next election against UKIP, rather than Labour, and that they are planning to leave the new Labur government in 2015 a number of huge time bombs.

Help to Buy could be a very clever move to stoke the credit bubble to both soothe back tory voters currently voting UKIP, and to raise the chances of a huge crisis after 2015, including in nationalized blackholes, as they are currently being kept theoretically alive only by rising collateral prices.

Ralph Musgrave

Fantastic claims that “regulation cannot stop boom-busts”. It’s true that nothing can stop humans marking up the price of their assets (houses, shares or tulips) when there’s an outbreak of irrational exuberance. But at least we can stop private banks exacerbating the process.

Fantastic is right to say that whatever regulations are imposed, some ars*hole like Hank Paulson is likely to undo them at a later date. The only way round that is ultra-simple regulations: clear lines in the sand. That’s why, like Milton Friedman, I favour 100% capital ratios, i.e. full reserve banking.

Dipper is completely wrong to claim that higher equity ratios wouldn’t have stopped banks crashing. It’s very rare for a bank’s assets to fall to less than about 80% of book value. Thus given an equity ratio of 20%, the value of the shares might fall to near zero, but the bank won’t go insolvent.

Re Frances’s arguments for counter cyclical capital ratios, that strikes me as wholly impractical, and for reasons which she herself set out. What does reduce the pro-cyclical effects of private banks is high capital ratios. Those high ratios make it impossible for banks to go insolvent, so there are no Lehman type events.

Blissex,

Re high capital ratios making insolvency impossible, I’m baffled by your claim that that is a “pointless truism”. Strikes me that if banks can’t go insolvent, that is a huge advantage: no Lehman type events, plus the severity of credit crunches is much reduced.

And as to your four other “factors at play” (e.g. “risk of the credit book”) those don’t make the above point about high capital ratios making insolvency impossible “misleading”. That is, if capital ratios are high enough to cover any conceivable loss (including those stemming from your four factors) then banks can’t go insolvent!!! That’s a big improvement, isn't it?

As to your point about voters being responsible, I agree. That is, voters are always demanding the Moon while refusing to pay for it, while politicians are happy to promise to deliver the Moon at no cost. For example voters demand the right to interest on their deposits, but refuse to carry the risk involved in having their money loaned on. That means that taxpayer DOES CARRY the risk. But of course politicians, or the 1% of them who understand the latter point, keep quiet about voters’ hypocrisy / ignorance.


Blissex

«how much of the extra GDP was in his opinion due to the credit boom? His answer - 150% of it - was in hindsight spot on.»

Indeed, indeed.

One of the more entertaining aspects of this is that while capital gains income is not counted as part of GDP, spending the money borrowed against those capital gains is counted as part of GDP.

The described in the comment above is also reported in my usual quote:

http://www.opendemocracy.net/ourkingdom/oliver-huitson/thatcher-black-gold-or-red-bricks
«Another of Thatcher’s magic potions was ‘home equity withdrawal’ or remortgaging – drawing down the equity in the borrowers home for (mainly) consumption purposes – new cars, holidays, and so forth.
Under the two Prime Ministers that preceded her, James Callaghan and Ted Heath, home equity withdrawal as a percentage of GDP growth was around 36% for both.
Under Thatcher, this exploded to over £250bn across her premiership – a staggering 104% of GDP growth. [ ... ]
But Blair did his homework and let loose – as did Thatcher – a wave of cheap credit, financial deregulation, house price inflation and an equity withdrawal-led consumption boom.
Withdrawals under Blair’s leadership totalled around £365bn, that’s a full 103% of GDP growth over the same period,»

Dipper

Blissex absolutely nails this, and not just because of an agreement with one of my statements!

There have been various "if only" analyses of the banking crises. If only regulations had been stronger; if only greedy bankers had been jailed; if only self-certification mortgages had not been allowed; and now if only equity ratios had been adjusted. All these miss the key point that the property/credit boom across the US and the UK was a giant voracious financial beast that destroyed any and every attempt to control it, and only stopped when there was no-one left to lend to.

The scale and cause of the underlying crisis seems generally uncomprehended. Currently we are borrowing money at £2000 per person per year, and over the course of this government this number has hardly budged. To me that seems a huge problem, but if someone is about to tell me that it isn't then please also explain why we can't borrow £10K per person and all take life a little easier.

The general explanation is that this debt is okay because the world is prepared to fund it. That's the financial equivalent of Hooke's Law, which is corrrect right up to the point when it isn't and disaster occurs. A similar point about market acceptance used to be made when people pointed out the enormous amount of debt that was being accumulated in the boom years, and we all know how that ended.

Ralph Musgrave

Dipper, I’m happy to explain how borrowing can make life “a little easier”. All the borrower needs to is to make sure the real or inflation adjusted rate of interest is negative (which it has actually been for the UK, US, Germany and some other countries at various stages over the last five years or so).

Any time you want to supply me with real goods and services in exchange for inherently worthless bits of paper, which I redeem in a few years time after inflation has eroded their value, please let me know. That will, as you put it, make life “a little easier” for me.

Luis Enrique

I shouldn't disagree with the BoE but I'm going to. Banks do intermediate between savers and borrowers, look at all the effort they make to attract savers, look at their balance sheets. It's just that they can lend first, finance that lending in the short run by any number of means, but over the long run they want depositors to make up a large part of the liability side of their balance sheet. Intermediation happens.

This is one of the most over-hyped issues in economics - the standard econ account versus the post-keynesian econ icon oclasts. It's just not a big deal - lend first then finance second or finance first and lend second, it's all happening at once in any case.

"lending creates deposits" is part of the standard text book econ version of events (I should know, I spent 3 years teaching it) if you are talking about within the banking system. If you are talking about within an individual bank, it's technically true but utterly unimportant, it's just like me saying that I am going to lend you £10, and I have created a deposit account for you with £10 in it at the bank of Luis Enrique. Nothing has happened, these are notional entries in a ledger book. If you want to withdraw that £10, I need to find the money from somewhere, and I cannot "create" it. The way some of these people crap on (Murphy) you wonder why banks ever get into trouble, what with their ability to create money out of thin air.

The text book money multiplier is fine if 1. taught as a simple parable, not a literal description of reality and 2. it is taught as an accounting identity. This is how one ought to read economics textbooks. The only thing that's really wrong with it, imho, is if it's used to claim bank lending is always pushing up against a funding constraint such that they can only lend after new deposits have been attracted.

Simon Reynolds

Luis,

I'm trying to understand.

Why hasn't the bank of Luis Enrique created money in your example?

Say your bank gives me a loan of £10, and I then withdraw £10 from your bank.

You say that your bank needs “to find the money from somewhere” and that the bank cannot create money.

But don't you and the central bank together create the £10?

The BoE paper says

“As discussed earlier, the higher stock of deposits may mean that banks want, or are required, to hold more central bank money in order to meet withdrawals by the public or make payments to other banks. And reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheets. In no way does the aggregate quantity of reserves directly constrain the amount of bank lending or deposit creation.”

Blissex

«I favour 100% capital ratios, i.e. full reserve banking. [ ... ] That is, if capital ratios are high enough to cover any conceivable loss (including those stemming from your four factors) then banks can’t go insolvent!!! That’s a big improvement, isn't it?»

And a pony for every borrower and for every bank shareholder too! :-)

«And as to your four other “factors at play” (e.g. “risk of the credit book”) those don’t make the above point about high capital ratios making insolvency impossible “misleading”.»

The "misleading" was about considering only two factors in insolvency:

«high asset-to-equity ratio that got banks into trouble. RBS and Northern Rock didn't fail because lots of their loans turned bad. RBS failed because it didn't have a sufficient equity cushion to absorb losses at ABN Amro.»

when there are *four* main ones, and as I wrote the one that really mattered, the one that enabled the asset boom and the resulting shrinking of the asset-capital ratios, was as I wrote:

«The principal technique was overvaluing collateral, by failing to note that the nominal value of that collateral was highly sensitive to credit growth, that as credit expanded the value of assets given as collateral would go up»

and that includes secondarily the riskiness of the credit book, which nobody realized :-) was very highly (inversely) correlated with credit growth.

Loss reserves, of which equity is part, were *in accounting terms* entirely adequate before the crisis struck, because value-at-risk models showed that the collateral posted for the credit book covered the entire value of the loans and entirely risk-free, as events proved :-).

It was the ever rising value of the collateral and its being risk-free that allowed banks to extend credit with a 105% or even 120% loan-to-value ratio in some cases, and on an interest-only basis too.

The debt-collateral spiral is, as George Osborne has realized too, a superb tool for never ending, massive, tax-free capital gains income to reward the hard working, highly productive, aspirational, deserving asset rentiers. :-)

Luis Enrique

Simon,

I was taking issue with the idea that banks don't need deposits to lend because "lending creates deposits". If you take standard econ (parable) you walk into a bank and deposit ten pound coins. The bank keeps two in its vault, lends out 8 which are taken by the borrower, spent and deposited in some other bank ( that's one sense in which lending creates a deposit). In this story the bank needs the deposit to finance the loan. Money has been created, there is now 18 pounds in circulation, the 10 you have on deposit and the 8 borrowed and spent. The 10 pound coins have been multiplied.

Another versions is that you agree a £10 loan with me, and I say, okay you now have £10 on deposit with me. This is a loan creating a deposit in a different sense, when the loan is agreed but before anything else has happened. And yes money had been created, you can regard that 10 as money at your disposal. Some people want to argue that because lending creates a deposit like that, banks don't need despositors (or other sources of finds) to lend. This is what I am disagreeing with. If you want to withdraw that 10, I don't have it, I have to find it from somewhere, I cannot just create it put of thin air. Some people forget this bit. A depositor could walk through my door and deposit some money which I can then give to you, in which case we have the simple econ story with the order changed, or as that excerpt you quotes has it, I could borrow from the BofE. But banks don't want to finance all their lending with borrowing from central banks, so they end up seeking depositors instead. So the essence of the simple story is intact, banks end up financing their lending with deposits, and intermediate savers and borrowers. However, as that excerpt notes, reserves do not constrain lending as they would if you took simple story with exogenous quantity of high powered money literally.

Blissex

«If you want to withdraw that 10, I don't have it, I have to find it from somewhere, I cannot just create it put of thin air. Some people forget this bit.»

Of course you forget that banks can do "out of thin air". You cannot, but banks (in the aggregate) can. It is just an accounting rule. That's why a banking license is such a difficult thing to acquire, and bank regulation and capital/asset ratios are so important.

And the central banks blesses the £10 loan, because as the BoE says «reserves are, in normal times, supplied ‘on demand’ by the Bank of England to commercial banks in exchange for other assets on their balance sheets».

Those «assets on their balance sheet» are the loans that the bank has, and the process is called discounting.

Simplifying a bit. the bank loans £10 to the client by crediting £10 on the client's account with the bank (the "thin air" phase), in exchange the client gives the bank an IOU that is accounted as an asset to the bank, and that's it, it all squares.

Then if the client wants to take £5 in banknotes from their account showing a £10 credit (the loan), the bank presents the IOU from the client to the BoE, and they happily "discount" that asset and send the bank some crisp new banknotes.

That's the big deal with banks, and why banking is always a state controlled function (like energy or armaments).

In effect the bank's accounts are money, and as someone very wisely said, creating money is extremely easy, anybody can create their own money, the difficulty is getting it accepted by those you want to buy stuff from.

You can try to buy a car with a piece of paper with written on it "this note is a cashier cheque for 10,000 Luises drawn on the Bank of Enrique". :-)

In the case of banks, the "accepted" (from the BoE) bit comes from having a banking licence, and therefore a banking account with the BoE; and in the case of the BoE the "accepted" bit comes from the British Armed Forces, who enforce the "legal tender" story. Money is what an accounting unit becomes when it is backed by guns.

Ralph Musgrave

Louis Enrique,

I agree with your "disagreement" with the BoE. That is, commercial banks do intermediate. Or put another way, I can think of plausible circumstances in which a commercial bank cannot lend unless it first receives deposits of some sort (if not from traditional retail depositors, then from bondholders etc).

But that's not to deny that the commercial bank system also lends money into existence.

Luis Enrique

Blissex,

I haven't forgotten anything. I described how the banking system in aggregate creates money but the words you quote from me were about an individual bank, and as I wrote and you go on to describe if the bank doesn't have reserves on hand when it needs to honour the loan agreement, it borrows from the BoE, it cannot create money out of thin air itself.

Ralph, I cannot think of circumstances in which a deposit must precede lending, unless there are times when the BoE won't provide?

Blissex

«if the bank doesn't have reserves on hand when it needs to honour the loan agreement, it borrows from the BoE, it cannot create money out of thin air itself.»

Please reread more carefully what I have written. I wrote about *banknotes* as creating BoE *banknotes* out of thin air is a crime. Plus thinking that only BoE *banknotes* are "money" is a silly thing indeed.

The bank customer can very well decide to pay for their purchases with cheques rather thank banknotes. In that case the bank issues them a chequebook. As long as the seller *accepts* cheques drawn on that bank, there is no need to get the BoE to print some crisp new banknotes (that are nothing else than bearer cashier cheques drawn on the BoE...).

Eventually the seller who accepts that cheque will deposit it into their account with the bank (the same or another makes little difference), and it all squares again.

Sometimes I get impatient when I read MMT stories because the MMT guys think they discovered something amazing, when in non anglo-american countries these things are part of tradition...

BTW, it occurs to me that the "traditional" explanation I reported that *banks* create "money" out of thin air is not quite right.

Who has actually created the "money" is the *borrower*! (remember that you read it here first :->)

Because the whole thing starts when the borrower deposits a previously non-existing IOU (created out of thin air or at least paper and ink) with the bank, and the bank gives them their own IOUs (chequebook) or the BoE's IOUs (banknotes) in exchange.

The logic behind the above is always and only *acceptance* by sellers as people borrow "money" in order to buy something from a seller.

Buyers borrow by depositing their own IOUs into banks to get bank IOUs because they assume that sellers will accept the bank's IOUs but will not accept their own IOUs.

This has as a corollary: it is *sellers* that extend credit, not banks, and they prefer to extend credit to banks (by accepting their cheque IOUs) or to the BoE (by accepting BoE banknotes IOUs).

Otherwise if a seller were to accept the IOUs of the buyers, why should the buyers (and the sellers) pay a bank "interest"/"seignorage" to act as middleperson?

And as a consequence, bad things happen when sellers no longer accept the IOUs ("money" as cheques) of banks, and ever worse things happen when they no longer accept the IOUs ("money" as BoE banknotes) of the BoE, and that's why the acceptance ("legal tender") of BoE banknotes is backed by lots of guns.

Of course the question is why should a bank issue their own well-accepted IOUs or those even better-accepted of the BoE in exchange for a random customer's IOU deposited with them.

And that's a difficult question indeed, and that's why it is a matter of estimating risk and collateral and loss reserves, and why so much recent and widespread financial fraud is based on clever customers depositing with banks IOUs collateralized with great "optimism".

Bank management may also have a great personal interest in accepting optimistic collateral for the IOUs deposited with them by customers, if they get significant commissions every time they issue a bank IOU in exchange...

Blissex

«The logic behind the above is always and only *acceptance* by sellers as people borrow "money" in order to buy something from a seller.»

Put another way, licensed banks effectively "endorse" buyer's IOUs (by swapping them with their own), and the BoE effectively "endorses" the IOUs of licensed banks (by swapping them with banknotes), and the guns of the British Armed Forces "endorse" the IOUs of the BoE as "legal tender".

But ultimately money is a unit of account of a debt relationship between buyers and sellers; and banks don't trade credit, or IOUs, they effectively trade endorsements.

The reason why I mentioned that a "cheque for 10,000 Luises drawn on the Bank of Enrique" usually does not buy a car was to hint that a random car dealer has little reason to trust you will pay (e.g. with your labor) your own IOUs, but more reason to trust a cheque (endorsed) from a licensed bank, and even more to trust 100 cheques for £100 (endorsed) from the BoE.

If the above entries are not the most direct and clear explanation of how "money" and banking work, let me know... :-)

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